The Banking Sector: Better, with Room for Improvement

Five years after the 2008 financial crisis, the US financial system – the proximate cause of the crisis – is in much better shape. Leverage levels are considerably lower and a regulatory overhaul has left US financial institutions better capitalized and less risky. In addition, a rising-rate environment like the one we’re in today has historically helped boost banking sector profitability.

This good news is a big reason why my team and I are less bearish on the global financials sector than we have been in the past. In fact, inour latest Investment Directions monthly market outlook, we upgraded the sector to neutral from underweight mainly because ofour improved outlook on US financials, which dominate the global financials index, and our expectation that rates will moderately rise over the next year.

However, now for the bad news: We only moved our outlook up to a benchmark weight for two reasons:

1.) More work still needs to be done in shoring upthe European banking sector. US banks are in better shape, and are further along in the recapitalizing and deleveraging processes thanEuropean banks. In addition, relative to the size of their respective economies, the European banking sector is considerably moreleveragedthan the US one, meaning additional deleveraging by European banks will hinder their profitability. In addition, the European economy is more dependent on bank lending. In Europe, 81% of corporate borrowing uses bank intermediaries versus 16% in the United States. As such, slower European economic growth, related to deleveraging, will likely lead to lower earnings for European banks. The bottom line: The gap in profitability between European and US financials is unlikely to close anytime soon (thereturn on equityfor the US financials sector is currently 8.2% as compared with 4.5% for the European sector).

2.) The regulations designed to make banks less risky may impair the global banking sector’s profitability going forward. In the wake of 2008 financial meltdown, new regulations across the globe have significantly increased the amount of capital that banks must hold, reduced fee income streams and led to much higher regulatory compliance costs. And the tight regulations are likely here to stay given that politicians will probably err on the side of restriction going forward to help prevent a repeat of the 2008 crisis.

So what does this mean for investors? Besides advocating that investors stay neutral the financial sector overall, we believe that there may be pockets of opportunity within the broader sector. In particular, over the longer term we like:

  • Segments that are relatively insulated from regulatory uncertainties as compared to investment banks. Such segments include US retail banks and US regional banks.
  • US banks versus European banks. Looking forward, although the profits of global financials will be lower relative to pre-crisis levels, we believe US financials are now better prepared to weather these changes than their European counterparts.

Sources: Investment Strategy Group Research, Bloomberg

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